Shareholders who are employed by a corporation which has elected to be taxed as an S-Corp wear two hats.  They are investors in the entity (they contributed capital to get their shares initially) and allowed to get a return on their capital, and they are employees who receive wages.  When an owner/employee of an S-Corp (or an LLC which is taxed as an S-Corp) is on a salary from the S-Corp, the wages payable are subject to employment taxes, and distributions made to the owner of the S-Corp are not subject to employment taxes.  Also if the S-Corp was loaned money by the shareholder, the S-Corp can make payments to repay the loan to the shareholder, and these payments will not be subject to the employment tax.  Misclassifying payments as distributions or loan repayments, when they really should be wages can lead to an audit from the IRS.

In a recent case from the United States Tax Court (Glass Blocks Unlimited, TC Memo, 2013-180), the sole shareholder of an S-Corp contributed cash into the S-Corp account.  Then for the next two years he received a salary from the S-Corp of $31,000, although he did not report this as income on his own tax returns for each of the two years, and the S-Corp did not report the payments made to the shareholder as wages, and did not issue Forms W-2, 1099, or Form 941.

When the shareholder was hauled in to court, he claimed that the payments were repayments of the initial loans he had made to the S-Corp, or alternatively, they were distributions (as they would not represent unreasonable compensation).  In either event, argued the taxpayer, they were not subject to employment tax.

The Tax Court found the argument unconvincing and held that the cash the shareholder initially placed in the S-Corp was the shareholder capital contribution (the amount he paid to receive his shares in the S-Corp), and not bona fide loans.  The Court relied on the multi-factor test in Calumet Industries, Inc. CCH Dec. 46,872 (1990), which is to look at the following:

The names given to the certificates evidencing the indebtedness;

Presence or absence of a fixed maturity date;

Source of payments;

Right to enforce payments;

Participation in management as a result of the advances;

Status of the advances in relation to regular corporate creditors;

Intent of the parties;

Identity of interest between creditor and stockholder;

Thinness of capital structure in relation to debt;

Ability of corporation to obtain credit from outside sources;

Use to which advances were put;

Failure of debtor to repay; and

Risk involved in making advances.

Id. (citing Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980) and Anchor National Life v. Commissioner, 93 T.C. 382, 400 (1989)).

The Tax Court found convincing the fact that there were no written notes or loan documents, and the S-Corp did not report the transfer on its tax return. There was also lack of proof that the shareholder required interest be paid on the loan, that the S-Corp provided any security on the loan, or that there was a regular repayment shedule.   The big factor was that because the payments to the shareholder would only be made upon the success of the S-Corp, the transfer of funds initially was a capital contribution and not a loan.

The shareholder’s other argument, that the payments were distributions and not wages was also not accepted by the Tax Court, because all of the S-Corp’s income was due to the efforts of the shareholder.